How to Profit From Revisions in Analysts' Earnings Estimates

by Wayne A. Thorp

Earnings play a pivotal role in the long-term viability of a company, as well as its investment prospects.
The market is forward-looking and stock prices are established, in part, on the basis of expectations for the companys future. Over time, prices adjust as expectations change or are proven wrong.

In short, while companies are often rewarded for having strong historical growth, changes in earnings expectations, no matter how slight, can have a significant impact on a stocks price.

What drives estimates?

Earnings per share (EPS) estimates involve the interaction of many company, industry, and economic forces. They embody an analysts opinion of such factors as sales growth, product demand, competitive industry environment, profit margins, and cost controls. Earnings are a key variable used to value stocks and, as a result, slight changes in expectations for future earnings or the earnings growth rate can translate into a significant and lasting impact on stock prices.

Services such as I/B/E/S, First Call, Reuters, and Zacks provide consensus earnings estimates by tracking the estimates of thousands of investment analysts (see Hot Links on page 18 for a listing of services tracking analyst estimates).

Tracking these expectations and their changes is an important component of stock analysis. In addition, tracking significant revisions can be turned into a rewarding investment strategy.

Screening for Revisions

A simple way to isolate companies whose consensus earnings estimate has been revised recently is through screening. AAII tracks a series of separate screens that look for companies with recent revisions. The screens are basic and simply focus on revisions to current and next fiscal-year estimates without any additional fundamental or price momentum-based considerations.

The AAII screens focus on two types of revisions:

The upward revision screen seeks companies whose revisions are positive—the latest earnings per share estimates for the current fiscal years are greater than they were one month ago and there have been no downward revisions of earnings estimates for the current fiscal year as well as the next fiscal year over the last month.

The downward revision screen seeks companies whose revisions are negative—the latest earnings per share estimates for the current fiscal years are lower than they were one month ago and there have been no upward revisions of earnings estimates for the current fiscal year as well as the next fiscal year over the last month.

Two additional screens require a minimum 5% estimate change for both the current and next fiscal year, to see if significant upward or downward revisions have a greater impact on stocks.

Stock Investor Pro, AAIIs fundamental stock screening and research database, includes these four screens for stocks with earnings estimate revisions.

The specific screening criteria used for these analyst revision screens are listed at the end of this article.

Screen Performance

AAII tracks over 50 stock screening methodologies and reports the companies passing each of these screens on AAII.com each month. In addition, members can view the performance of simple hypothetical portfolios invested in the companies passing these screening methodologies that have been backtested over the last seven years. The four screens for upward and downward earnings estimate revisions are part of this analysis.

As you can see, stocks with upward earnings revisions have clearly outperformed stocks with downward revisions. Changes in stock price resulting from an earnings revision can be, and often are, felt immediately. But studies also indicate that the impact of surprises and revisions can persist for as long as a year. Even though the greatest impact on stock price was felt in the month of the revision, the strategy still worked when comparing the current consensus estimate to the previous months estimate (which is what the screens look for).

The performance chart and table also highlight the fact that, although stocks with significant (5% or higher) upward revisions certainly benefited from their significant revisions, stocks with 5% or greater downward revisions did not necessarily fare worse because of their significant revisions. This may be due to stocks bouncing back from an initial overreaction to downward revisions or industry concentrations that still performed strongly despite downward revisions.

Profile of Passing Companies

The characteristics of the stocks from the upward and downward estimate revision screens are presented in Table 1.

Table 1. Earnings Revision Screens’ Portfolio Characteristics

Portfolio Characteristics

EstRevUp

EstRevUp5%

EstRevDown

EstRevDown5%

AllExchange-ListedStocks

Price-earnings ratio

21.1

18.4

20.2

25.8

20.5

Price-to-book-value ratio

3.04

3.01

2.26

1.70

2.20

EPS 5-yr. historical growth rate

17.9%

28.3%

14.4%

13.0%

10.0%

EPS 3-5 yr. estimated growth rate

14.4%

13.7%

13.3%

15.8%

14.4%

Monthly change in current year est.

1.3%

8.3%

(2.1%)

(16.8%)

0.0%

Market cap (million)

$2,430.7

$1,148.5

$1,709.2

$683.2

$411.0

Relative strength vs. S&P

27.0%

30.0%

(11.0%)

(20.5%)

1.0%

Monthly Observations

Average no. of passing stocks

167

41

193

69

Highest no. of passing stocks

413

142

538

170

Lowest no. of passing stocks

44

4

79

17

Monthly turnover

81%

93%

79%

90%

Table 2 lists the 15 companies with the highest percentage increase in current-fiscal-year earnings estimate over the last month, along with the 15 companies with the highest percentage decrease in current-fiscal-year estimate over the last month. These screening results are as of July 8, 2005.

The stocks with 5% or higher upward revisions, interestingly, have a lower median price-earnings multiple (18.4) than the typical exchange-listed stock (20.5), but have a median price-to-book ratio (3.01) that is higher than the 2.20 median value for exchange-listed stocks. Overall, however, there is not a dramatic difference from the norm among the median valuation ratios for the companies passing these earnings revision screens.

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The stocks with 5% or higher upward earnings revision exhibit significantly higher median historical earnings growth (28.3%) than the stocks passing the other earnings revision screens as well as exchange-listed stocks. However, their median future estimated earnings growth is more in line with the stocks from the other screens and the typical exchange-listed stock.

In addition, the stocks with 5% or higher upward earnings revisions have the highest median relative price strength over the last 52 weeks, outperforming the S&P 500 by 30.0%.

This screen, perhaps, is isolating stocks that have suffered financially in the past, but are now showing signs of a turnaround, with rising earnings estimates that the market recognizes through price appreciation. Our screens select stocks with upward revisions after the revisions and subsequent price increase, and select stocks with downward revisions after they have underperformed the market.

The earnings estimate revisions screens produce among the highest level of monthly turnover of all the screens tracked by AAII. Over the last seven-plus years, between 79% and 93% of the stocks passing one month fail to pass the revision screen the next month. This is due to the nature, and frequency, of analyst earnings revisions, which are not constantly taking place.

We also find a high level of industry concentration among the companies that are currently passing the earnings revision screens. Among the 15 stocks with the greatest upward estimate revisions, six are in the oil & gas operations industry and another, Plains All American Pipeline, is in the oil well & services industry. All of these companies are benefiting from the near-all-time high oil prices we have seen for the last several months.

Given the nature of the screening criteria for these screens, it is not surprising to see that stocks passing the two upward revision screens have positive median percentage increases in current-fiscal-year earnings estimate over the last month, while the downward revision stocks have had a decline.

Nor should we be surprised to see that the magnitude of this percentage change in current-fiscal-year estimate is greater for the 5% revision screens.

Among the stocks in Table 2 with the highest upward revisions, Equinix, Inc. (EQIX), a data services firm, had the largest percentage increase in current-fiscal-year estimate over the last month at 30.8%. Of the six analysts that track the stock, five raised their estimate over the last month, raising the consensus earnings estimate for Equinix from -$0.39 per share to -$0.27 per share. This resulted in the 21.3% increase in EQIX shares for the four-week period ending July 8, 2005.

On the other side of the equation is Adaptec Inc. (ADPT), a maker of storage tools for network servers and computers, which has the largest percentage decline in its current-fiscal-year earnings estimate over the last month at -750.0%. On April 26, the company announced that its president and CEO was retiring, effective immediately. Then on June 29, the company provided downward guidance for its first-quarter results that were below analyst consensus estimates.

Over the last month, all six of the analysts tracking Adaptec downwardly revised their current-fiscal-year earnings estimate for the company from -$0.02 per share to -$0.17 per share.

Conclusion

While the results of the upward earnings revision screens have shown promising results over the last several years, it is important to note that these screens are only first-cut screens. They do not examine issues such as financial strength or liquidity. Instead, they highlight the importance of changes in expectations and their impact on stock prices and the potential benefit of adding an earnings revision consideration to a more robust set of filters.

Furthermore, the companies passing these—or any other stock screens—do not represent a recommended or buy list of stocks. Any stocks that turn up from any quantitative stock filter require further analysis by the investor. It is important to perform due diligence to verify the financial strength of the passing companies and to identify those stocks that match your investing constraints and requirements before committing your investment dollars.

What It Takes: Earnings Revision Screens Criteria

Upward Revision Screen:

There are at least four analysts providing earnings estimates for the current fiscal year;

The latest earnings per share estimates for the current and next fiscal year are greater than one month ago;

There has been at least one upward revision of earnings estimates for the current fiscal year as well as the next fiscal year over the last month;

There have been no downward revisions of earnings estimates for the current or next fiscal year over the last month.
These criteria are simply reversed for the downward revision screen.

5% Upward Revision Screen:

There are at least four analysts providing earnings estimates for the current fiscal year;

The latest earnings per share estimates for the current and next fiscal year are greater than one month ago;

There has been at least one upward revision of earnings estimates for the current fiscal year as well as the next fiscal year over the last month;

There have been no downward revisions of earnings estimates for the current or next fiscal year over the last month;

The percentage increase of earnings estimates for the current fiscal year as well as the next fiscal year over the last month is greater than or equal to 5%.

These criteria are simply reversed for the 5% downward revision screen.

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